European stocks not as cheap as the headline numbers suggest

June 11, 2013|Reuters

* European index valuations around 10-yr average

* Only energy, utilities and telecoms cheap vs history

* Number of expensive blue-chips highest in a decade

By Toni Vorobyova

LONDON, June 11 (Reuters) - European equities look fairlypriced but only because average values are being kept in checkby a handful of sectors with poor outlooks, meaning a good dealcould be hard to find.

The pan-European benchmark index, the STOXX Europe 600 is up a quarter since last June and trading at 12.7times its companies' expected earnings over the coming year.That is just above the average of the past decade and aroundthree-year highs.

"Europe is not as cheap as the headline numbers suggest,"said Mark Hargraves, manager of the AXA Framlington EuropeanFund. "There are two or three sectors where they are materiallytrading below (historical averages) and quite a number of stocksand sectors are trading considerably above."

Utilities face regulatory hurdles and politicalbarriers to raising prices, energy companies arebattling higher production costs and are at the mercy of globalprices and demand for oil. Telecoms, meanwhile, face toughcompetition, especially in the move to mobile networks.

These three sectors have the lowest earnings growthexpectations for 2014 among STOXX Europe 600 sectors, accordingto Thomson Reuters StarMine SmartEstimates, at between 2.7 and5.9 percent, compared with the index average of 13 percent.

"When I look at those three sectors I am very cautious,"Hargraves said. "They are all trading at what superficiallylooks like ... cheaper multiples, but the challenge there isthat you've got a mixture of potential value traps (cheap stocksthat may fall further) and earnings uncertainty."

The need to dig deep for bargains is even more acute at thestock level, with 240 of the companies in the STOXX Europe 600trading above their 10-year average price-earnings ratio, twiceas many as a year ago.

The valuation of the market as a whole, meanwhile, revealsthat investors are most willing to pay for strong cash flow.

By contrast, European equities are cheapest on book value,the price companies put on their assets, which is vulnerable towritedowns. This is especially true of banks, where loanbooks have been hit by borrowers' declining financial health.

SHRINKING

The average valuations also mask the fact that the last timethe market was at such price ratios, the euro zone economy wasin much better shape, posting steady growth rather thanshrinking as it did at the start of this year.

"From here, I can't see the multiples expanding too much ina hurry - now it's a case that we need to get profit growthcoming through to drive prices higher," said Kevin Lilley,European equities fund manager at Old Mutual AM.

Information technology, industrials and materials have thehighest prospects for earnings growth next year, based onStarMine SmartEstimates, which weigh forecasts based ontimeliness and on the analysts' accuracy.

However, those sectors offer below-average dividends,potentially missing the criteria of those investors who areturning to equities as an alternative to low bond yields.

Compared with bonds, stocks still offer value. The gapbetween the STOXX 600 dividend yield and German government bondyields has narrowed slightly in recent months, butat 1.6 percentage points in favour of stocks, shows equitiesclose to their most attractive levels of the past 15 years.

"When you start comparing to where else you could put yourmoney, then equities start to look very attractive," said LarsKreckel, global equity strategist at Legal & General InvestmentManagement.